When you begin investing, stocks and bonds may be a natural place to start. These types of securities can help you build a base for your investment portfolio, whether you’re in it for the long-run (e.g. retirement) or working toward shorter-term goals. But once you’ve found your footing in the market, you may be itching to expand your investment portfolio and explore alternative avenues to grow your investment portfolio.
That’s where REITs, or Real Estate Investment Trusts, come in. Investing in REITs helps you enter the real estate market and add diversification, as well as steady income, to your portfolio.
So, could REITS be a good option for you? Read on to learn more.
Understanding REIT Basics
A REIT is a company that owns and often operates real estate, such as shopping malls, apartment buildings, or hospital facilities, and earns income from doing so. The REIT generates income by leasing out the spaces it owns and manages to tenants, who pay rent. Typically, REITs operate in a certain sector (like healthcare or retail) and own a number of properties within that sector.
The two main types of REITs are classified as equity REITs and mortgage REITs (mREITs), though some REITs may operate as a hybrid.
Equity REITs are the most common, and this type owns income-producing real estate.
mREITs, on the other hand, don’t own property themselves. Instead, they provide financing for income-producing real estate. They do this by lending money for mortgages or acquiring mortgages or mortgage-backed securities. mREITs earn income based on the interest paid on the loans by borrowers.
Companies have to meet several requirements to qualify as a REIT. For example, they must invest at least 75% of total assets in real estate and at least 75% of gross income has to come from rent, interest on mortgages financing real property, or sales of real estate. And, each year, at least 90% of a REIT’s taxable income must be returned to shareholders as dividends.
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The Value of REITs: Diversification and Dividends
Like any investment, REITs carry some risk, but they can also add value to your portfolio, for instance, through diversification and dividend income.
A diversified portfolio is one that’s made up of a range of investments in different asset classes — that can mean a combination of different stocks and bonds, as well as a mix of industries, sectors, and geographies. A healthy amount of diversification in your investment portfolio can help shield you from risk during times of market turbulence. That’s because you’re not as reliant on one single company or industry’s success.
Investing in real estate, whether through REITs or physical property, can help diversify your portfolio. Why? REITs, which are made up of real estate holdings, might not be impacted as severely by the same market forces that can cause volatility in the pricing of stocks and bonds.
Some REITs also offer risk-adjusted returns and income through dividends. As we mentioned earlier, a key qualifying characteristic of REITs is that they have to distribute at least 90% of their income to shareholders — meaning REITs can provide dividend-based income. Of course, REITs are also subject to market risks and volatility that can reduce or otherwise negatively impact the divided income you can earn from them or their underlying market value.
When you earn dividends from REITs, that income will be taxed at your ordinary income tax rate. You may keep your dividend yield as cash — or you can choose to reinvest your dividends. (You’ll be subject to tax obligations either way.) But reinvesting your dividends can create a similar effect to compounding interest, helping you maximize your returns through dividend growth over long run. You might find it helpful to consult a tax professional, if you have questions about the tax consequences of REITs (or any investment, really).
Keep in mind, because REITs are only allowed to reinvest up to 10% of their income, they may not be the ideal investment to achieve capital appreciation. And like any investment, there’s risk involved, as REITs may be affected by fluctuations in the real estate market and your investment can lose much or all of its value.
REITs vs. Actual Property
If you want to diversify your portfolio or make passive income through real estate, REITs could be the answer. They present the opportunity to invest in real estate without having to deal with the work of maintaining physical properties and collecting rental income from tenants.
In fact, you can buy and sell publicly traded REIT securities on the market through a broker, just as you would buy stocks, mutual funds, or exchange-traded funds (ETFs). You can also purchase shares of a public non-traded REIT through a broker participating in that REIT’s offering. Needless to say, purchasing property is not so easy.
REITs can be a more liquid investment than physical real estate, because the latter can take days, weeks, or months to buy and sell. And because these securities typically have low investment minimums, there can be a much lower barrier to entry than the physical real estate market.
REITs are also generally a more transparent investment, as both publicly traded REITs and public non-traded REITs are regulated by the Securities and Exchange Commission and file audited financial reports.
It’s worth noting that REITs can carry costs and expenses that are not associated with real estate transactions, so it’s important for you to familiarize yourself with a REIT’s disclosure filings and offering prospectus, which are available at SEC.gov, before investing.
Ready for REITs
If you’re interested in investing in REITs, whether as part of your retirement fund or to supplement another investment goal, you’re not alone. Approximately 87 million Americans have already invested in REIT securities, and another 21% of U.S adults are interested in them.
At Ally Invest, we offer the opportunity to invest in REITs through our Self-Directed Trading platform. With more than 225 REITs on the market, you can explore your options to see if REITs fit your investment goals — and if they might help bring you closer to achieving a future of financial wellness.
Are REITs right for your portfolio?